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DeWitt Wallace Fellow
Sen. Barbara Boxer (D) of California
announced this month she intends to move ahead with legislation
designed to lower the emission of greenhouse gases that are linked by
many scientists to climate change. But the approach she’s taking is
flawed, and the current financial crisis can help us understand why.
The centerpiece of this approach is the creation of a market for
trading carbon emission credits. These credits would be either
distributed free of charge or auctioned to major emitters of greenhouse
gases. The firms could then buy and sell permits under federally
mandated emissions caps. If a company is able to cut emissions, it can
sell excess credits for a profit. If it needs to emit more, it can buy
permits on the market from other firms.
Europe has in place a
“Cap and trade,” as it is called, is advocated by several
policymakers, industry leaders, and activists who want to fight global
warming. But it’s based on the trade of highly volatile financial
instruments: risky at best.
The better approach to climate change? A direct tax placed on
emissions of greenhouse gases. The tax would create a market price for
carbon emissions and lead to emissions reductions or new technologies
that cut greenhouse gases. This is an approach favored by many
economists as the financially sensible way to go. And it is getting a
closer look by some industry professionals and lawmakers.
At first blush, it might seem crazy to advocate a tax increase
during a major recession. But there are several virtues of a tax on
carbon emissions relative to a cap-and-trade program.
For starters, the country already has a mechanism in place to deal
with taxes. Tax collection is something the government has abundant
experience with. A carbon trading scheme, on the other hand, requires
the creation of elaborate new markets, institutions, and regulations to
oversee and enforce it.
Another relative advantage of the tax is its flexibility. It is
easier to adjust the tax to adapt to changing economic, scientific, or
other circumstances. If the tax is too low to be effective, it can be
raised easily. If it is too burdensome it can be relaxed temporarily.
In contrast, a cap-and-trade program creates emissions permits that
provide substantial economic value to firms and industries. These
assets limit the program’s flexibility once under way, since market
actors then have an interest in maintaining the status quo to preserve
the value of the assets.
What’s more, they can be a recipe for trouble. As my American
Enterprise Institute colleagues Ken Green, Steve Hayward, and Kevin
Hassett pointed out two years ago, “sudden changes in economic
conditions could lead to significant price volatility in a
cap-and-trade program that would be less likely under a carbon-tax
Recent experience bears this out. Europe has in place a
cap-and-trade program that today looks a little like the American
mortgage-backed securities market–it’s a total mess. The price of
carbon recently fell–plummeting from over $30 to around $12 per
ton–as European firms unloaded their permits on the market in an
effort to shore up deteriorating balance sheets during the credit
It is this shaky experience with cap-and-trade that might explain an
unlikely advocate of a carbon tax. Earlier this year, ExxonMobil CEO
Rex Tillerson pointed in a speech to the problems with Europe’s
cap-and-trade program–such as the program’s volatility and lack of
transparency–as reasons he prefers a carbon tax.
That said, new taxes are a tough sell in Washington, which helps explain the current preference for a cap-and-trade scheme.
Despite this, there are ways to make a carbon tax more politically
appealing. The first is to insist that it be “revenue neutral.” This
means that any revenues collected from the tax are used to reduce taxes
elsewhere, such as payroll taxes.
The advantage of this approach is that it places a burden on
something that is believed by many to be undesirable (greenhouse-gas
emissions) while relieving a burden on something that is desirable
Another selling point is that the tax can justify the removal of an
assortment of burdensome and costly regulations such as CAFE standards
for cars. These regulations become largely redundant in an era of
But it may be that a carbon tax doesn’t need an elaborate sales
pitch today when the alternative is trading carbon permits. The
nation’s recent experience with Fannie Mae, Freddie Mac, and the
mortgage-backed securities market should prompt Congress to think twice
when a member proposes the creation of a highly politicized market for
innovative financial instruments, no matter how well intentioned the
program may be.
Nick Schulz is the editor-in-chief of The American and the DeWitt Wallace Fellow at AEI.
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